Small and mid-sized business owners have a new option for providing employees with a tax-advantaged health care benefit-the health reimbursement arrangement.
Such an arrangement allows employers to provide reimbursements to employees for medical expenses that otherwise are not covered by an existing health care plan. Such expenses might include deductibles, co-payments, prescription drugs, non-covered services, out-of-network expenses, etc. The plan covers expenses incurred by the employee, the employee's spouse and the employee's dependents.
Employers establish a stated dollar amount that the plan will reimburse over a stated coverage period, usually annually. Any amount not used in the coverage period must be carried over to the next period. The reimbursement must be provided exclusively by a contribution from the employer, not a salary reduction for the employee.
Health reimbursement arrangements are similar in intent to cafeteria or flexible spending accounts, but there are some significant differences. Compared with the employer funding of a health reimbursement arrangement, the flexible spending account requires employees to set aside pre-tax dollars from their own salaries and then collect reimbursement for eligible expenses.
The flexible spending account also establishes a use-it-or-lose-it rule. If funds remain in the account at the end of the coverage period, the employee loses the money.
Health reimbursement arrangements offer employers and employees some tax advantages. The Internal Revenue Service does not regard the reimbursement as income to the employee. Instead, it is a tax-deductible expense for the employer.
As such, the employer can offer a benefit to employees that is not subject to payroll tax, and employees pay no income tax on any reimbursement.
It might be tempting for some companies to offer the health reimbursement arrangement because of the tax advantages, yet present it to employees as a salary-reduction arrangement. Employees might even be pleased with such a plan because it still would provide them with an untaxed amount for health expenses without the use-it-or-lose-it provision.
However, the IRS has made it clear that a health reimbursement arrangement must be employer-funded and cannot perform like a disguised flexible spending account. The specific manner in which a health reimbursement arrangement is offered in conjunction with other health care benefits-such as an accident or health plan-is important to assure it qualifies for health reimbursement arrangement tax treatment.
The IRS also polices other complex issues related to health reimbursement arrangements, such as nondiscrimination rules, contribution deductions, COBRA, etc. Health reimbursement arrangements generally are somewhat simpler for employers to administer, but the circumstances for each specific employer will vary based on a number of factors.
How does a company decide whether to offer a health reimbursement arrangement to its employees?
A health reimbursement arrangement is most beneficial when the employer offers an insured accident and health plan with high deductibles, high co-payments and significant coverage limitations.
If an employer faces a reasonable likelihood that there will be significant unused reimbursement to carry forward, a health reimbursement arrangement could result in continuous carry forwards, the outcome of which would be large liabilities.
To assure compliance with ERISA and best practices, the health reimbursement arrangement should be established and based on a written plan document that explains all the terms and conditions.
In our slumping economy, such an arrangement might prove enticing to companies looking to increase employees' income without a straight pay increase.
Peter A. DeMarco is vice president and director of the Tax Services Group of Meaden & Moore, a regional accounting and business consulting firm with headquarters in Cleveland. This article originally appeared in Crain's Cleveland Business, a sister publication of Tire Business.